At a very basic level, interest rates are percentage fees levied whenever one person has use of another person’s money. While the headline numbers can look small, they can have a very big impact so it really does pay to understand how they work.
Interest rates can be simple but they are more likely to be compound
Simple interest rates are based purely on the initial sum lent or borrowed. For example, if you lent someone £100 and charged 1% per annum simple interest, then each year you will receive £1 in interest. If, however, you charge 1% per annum in compound interest then the first year, you will receive £1 in interest but the second year, you will receive £1.01 in interest. This may not seem like much of a change but as the years go by, it will add up.
That was, of course, a very simple example. In reality, while simple interest really is simple, compound interest can be much more complicated as there can be all different kinds of ways of calculating it, which is why the annual percentage rate (APR) can come in very useful as a guideline to your financial “worst-case scenario”.
Different people (and companies) can be charged different rates for exactly the same product
If two different people (or companies) apply to exactly the same lender for exactly the same product, they can still be charged different rates for it. This is because the lender will assess risk and reward on an individual basis.
For example, let’s say two borrowers want to buy identical houses on a new-build development. One has a 10% deposit and is self-employed (albeit with the required level of documentation to show income) and the other has a 25% deposit and is fully employed, has been so for several years and works in a skilled and fairly secure profession. It’s easy to understand why a lender would see the second borrower as being far lower risk and hence want to attract them with a lower interest rate.
The good news here is that being aware of this reality is a crucial first step in understanding what it means for you and hence what you need to do to manage it. This basically entails looking at your situation as a whole and deciding where you are prepared to make compromises and where you are not. For example, if you are currently employed but want to go self-employed, then it may be best to wait until after you have bought a property and been approved for the necessary mortgage, or, if you are already self-employed, then you may want to make sacrifices elsewhere in your life so you can build as big a deposit as you possibly can.
Interest rates are in a constant battle with inflation
If you’re a saver then the only way you can make an effective (i.e. real-world) profit from your cash deposits is by earning an interest rate which is above the rate of inflation. If you are a borrower, then the only way you can earn a profit on the money you borrow is by generating a return which beats inflation after you have paid your lender interest on the sum which, as we have already seen, needs to make them a profit after inflation. Whatever way you look at it, inflation is the enemy of profit whether that profit comes in the form of interest rates for savers or investment returns for anyone. Of course, the fact that people do regularly manage to beat inflation shows that it is possible, however, it is important to keep the effects of inflation in mind when taking any financial decision, including assessing interest rates.
Your property may be repossessed if you do not keep up repayments on your mortgage.